Global Economics

Southeast Asia's Clean Air Conundrum

If you live in Singapore or Kuala Lumpur, the last several weeks have been hellish for you. A miasma of choking haze has sent pollution readings off the charts and health authorities are warning of much worse to come. As in years past, the foul air is the direct result of raging forest fires across the waters in Indonesia's Sumatra region as villagers and farmers clear land for logging and the export of tropical timber and planting of a variety of agricultural products.

Yet there is a weirdly paradoxical twist to this year's frenzy of pollution-generating deforestation: Indonesia's slash and burn wave owes much to the soaring demand for environmentally-friendly biofuel.

Plantation companies based in Singapore and Malaysia are willing to pay top dollar for land that they can plant with oil palm trees that bear fruit to be crushed to produce palm oil, typically used for cooking products. However, palm oil is also a key element in the production of Asian biodiesel, which burns more cleanly than traditional diesel fuel.

MONEY MAKER. The irony of setting fires and creating a pall of dirty air over much of Southeast Asia to boost production of cleaner energy hasn't been lost on environmental groups in the region. "Why are we burning our forests to plant something that we have been told will be clean, environmentally friendly fuel?" asks S.M. Idris, chairman of environmental lobby group Sahabat Alam Malaysia (Friends of the Earth). "This is technology gone mad."

Perhaps, yet there is also a lot of money driving the craze for biofuel, which is a blend of vegetable oils (or in the U.S., soybean oil) and traditional diesel fuel. Diesel blended with up to 10% vegetable oil in the total mix burns cleaner and does not require any engine modifications. Palm oil is one of Indonesia's biggest exports.

Oil palm trees grown close to the equator in Malaysia and Indonesia have a very high oil content. This makes palm oil one of the most economical of the vegetable oils that can be converted to diesel. Palm oil sells at a huge 15% to 40% discount compared with other vegetable oils such as rapeseed and soybean and is therefore commercially a more viable alternative energy source.

GREAT EXPECTATIONS. All this explains why companies in Southeast Asia are raising serious money to be players in biofuel. When plantation owner Wilmar International—controlled jointly by Malaysian billionaire Robert Kuok and U.S. agricultural giant Archer Daniel Midland (ADM)—listed on the Singapore exchange earlier this year, its stock nearly doubled within four months on the news that it was building one of the region's biggest biofuel plants. (The plant won't come onstream until 2007 at the earliest.)

Another biofuel producer, Indofood Agri-Resources, owned by Indonesian billionaire Liem Sioe Liong, is expected raise several hundred million dollars in an initial public offering at the Singapore Stock Exchange next month.

When crude oil prices rose to the $78 a barrel range earlier this year, Southeast Asia began building up biofuel capacity. Malaysia has already approved over 5 million tons of biodiesel capacity while neighboring Indonesia has approved nearly 3 million tons.

CRAZY SPENDING. Some 90 biodiesel plants are in various stages of construction and about 40 or so are on the drawing board in the two countries. The U.S. (the world's biggest oil consumer), by comparison boasts 86 biodiesel plants, with another 62 under construction.

Indonesian President Susilo Bambang Yudhoyono has described the biofuels sector as "a key engine of growth" in his country. Jakarta estimates some $2 billion could be spent on the biofuel sector in the country over the next four years and Malaysia could easily top that. "There is a lot of money being thrown at biofuel plants these days," says Yeo Howe, chief financial officer and executive director of IOI, one of Malaysia's largest plantations, whose own company has taken a wait and see attitude. "It's crazy."

But regional officials don't believe things are getting out of hand. Malaysian Commodities and Plantation Industries Minister Peter Chin says countries like his own are only catering to a growing global demand for cleaner alternative fuel. "It's all private-sector driven by plantation companies who obviously know what they are doing," he says. Citigroup estimates global biodiesel capacity will more than double to 13.5 million tons by the end of next year vs. 2005 levels.

AGGRESSIVE EXPLORATION. Analysts say three catalysts are driving the current biodiesel mania. High crude oil prices, the Kyoto Protocol on global warming, and the need to lessen reliance on crude oil. Though oil prices have fallen 20% from the peak in recent months, anything above $55 a barrel makes palm oil-based biodiesel a commercially viable option.

Moreover, adherence to the Kyoto pact on global warming, which sets limits on greenhouse gases (including carbon dioxide emissions), has made it necessary for countries to aggressively explore cleaner and renewable fuels.

Demand from Europe, where diesel fuel use is widespread, is also driving demand. Palm oil exports from Malaysia and Indonesia to Europe surged 19% last year—higher than the 15% growth in palm oil exports to China. South Korea and Japan are starting to emerge as large consumers of biodiesel as they try to reduce carbon emissions and their own dependence on oil.

HANDSOME REWARDS. Is this stuff really cost competitive? Some, such as IOI's Yeo, argue no, not at current and more moderate oil prices, especially when you screen out the lavish government subsidies and tax incentives being showered on producers. Malaysian palm-diesel plants, for instance, operate under a so-called "pioneer status."

That means that their profits are tax free for 5 to 10 years. "The key bet you are making right now by investing in a biofuel plant is not whether oil prices will be $70 or $50—but whether there will be political will to support the biodiesel industry" says Yeo.

If there is, the rewards could be handsome for investors. With the help of huge tax incentives, biodiesel plants can be fairly lucrative. Credit Suisse analyst Tan Ting Min figures that biodiesel plants have an annual rate of return of over 30% on invested capital and cover their upfront costs in less than three years. All of this sounds promising except for one thing: the biofuel boom right now seems to be inflicting more environmental damage than it is averting.